Tax Deductions that Build Wealth

Here are three great tax deductions will also make you wealthy. Make sure you are taking advantage of all of them. Maximize your refund and increase your wealth at the same time.

Wealth Building Tax Deduction #1 – Retirement Plans

In case you were wondering, it really does help reduce your yearly tax liability significantly when you contribute to your 401k, military TSP, traditional IRA, or similar type of plan.

When you contribute to these plans you are putting money into your savings. The tax advantage is that all or much of the money that you are putting away for yourself will be excluded from your taxable income.

So for example if you make $60,000 and contribute $5,000 of it to a tax deferred retirement plan, you will only be taxed on $55,000 of income. This is a massive benefit and it will increase your tax refund by quite a bit.

Another great tax advantage of these qualified retirement plans is that all of the savings in this account grow completely tax free. You can have interest, dividends, capital gains, etc – it’s not taxed at all until you withdraw the money. Income from your investments that avoids tax combined with the power of compounding creates a very effective wealth building situation for you.

Remember you still have to pay income tax on that money when you go to withdraw it – but this will very likely be tax at a lower rate and sometimes not taxed at all. Typically, by the time a retired tax payer starts taking distribution on their plan, they only have social security and investment income to add to it. Much of this is chopped down by the standard deduction (which increases when you are of retirement age) and personal exemptions. Also, part of your social security will not be subject to income tax as well.

It’s a great deal and you should give it consideration if you are not currently participating. Even if you start with a small contribution percentage, you will end up paying less tax and receiving a bigger refund (not to mention saving money for retirement).

Note that if you withdraw money from these accounts before you retire, you often have to pay a penalty.

Wealth building Tax Deduction #2 – Own a Home

With tax reform likely just around the corner, these deductions may no longer do as much good or be available for much longer. However, for now, mortgage interest, most mortgage insurance premiums, most home equity line of credit interest, most points that you pay when originate loans, and nearly all property taxes are tax deductible.

home owner tax deductionsWhen you have these,  you will probably “itemize” deductions instead of taking the “standard” one (unless the tax code changes under the new administration). Once you have enough deductions to itemize, you can include all kinds of deductions that did you no good when you were simply taking the standard.

As a result of all of this, home owners typically get massive refunds compared to non-home owners.

Another great wealth building thing about owning a home is the hedge against inflation that the investment creates. When you have a fixed loan amount your payments will stay the same for years to come. It doesn’t take long before you are only paying “half of what you pay” on the first year when you adjust for inflation. The property value will likely increase quite a bit over time as well.

Now this doesn’t have to be a huge house either. Any little condo or townhouse will do as well. Now you are building wealth by making payments toward your own asset rather than making a landlord rich, and you save big on your taxes while you do it.

Wealth Building Tax Deduction #3 – Invest in Rental Property

Just like with home ownership, you get all of those great tax deductions and wealth building advantages for a rental too – and more.

Similar to a home which you own that you live in, with property rentals you can deduct mortgage interest and property taxes. When you rent property, it becomes sort of like a business. You can also write off other expenses such as insurance, utilities, repairs, maintenance, and many other typical expenses.

rental income deductionsAnother deduction included with a rental is depreciation. Buildings and major appliances don’t last forever. You can divide the basis of your rental building by 27 and a half years and take that as an expense every year. Most appliances are depreciated over 5 years.

So even if you break even with rent compared to expenses, you will still have a loss on your tax return. Most middle class families can deduct this loss against their wages for a lower tax liability. If you are a family that earns a higher amount than average, you might not qualify to benefit from this loss however.

Rentals are also an excellent wealth building investment. Fixed mortgage rates means you will have payments that never increase – but the rent you collect increases with inflation. By the time your retire your rental will no longer be a tax write off but a source of great income. Just like retirement plan distribution income, this income will likely be taxed at a low margin when you are retired because you won’t have any taxable wages.

In summary, with a rental property investment, you often get a tax write off now and lots of income when you retire. This could mean when you travel you will be flying first class instead of coach in your later years. You will also hand down this wealth to your heirs.

Wealth Building Tax Deduction #4 – Long Term Capital Gains and Qualified Dividends

This isn’t really so much a tax deduction, but more of a tax that is a much lessor rate than ordinary income taxes. Taxes on long term gains (most investments held over one year) and qualified dividends have only three tax brackets – 0%, 15%, and 20% – depending on your total income. Planning you investment income to fall into these categories as much as possible can result in a significant tax savings, as well as great long term appreciation of your wealth.

When you invest in stocks that are held for more than one year, and these stocks pay dividends, you are perhaps looking at lower tax rates on the income from both the appreciation AND the dividends. It’s a win/win.

Note that this rate does NOT apply to short term gains – that is – income on investment property held for less than one year. Watch out also for dividends that are NOT qualified, such as dividends from real estate investment trusts, bonds, and many “preferred” stocks (which are kind of like bonds in many ways). These unqualified dividends are subject to ordinary income tax rates. Short term day trading, of course, does not qualify for the reduced rates either. Because of long-term capital gains tax benefits, and considering how difficult it is to make money trading in the short term, it might make more sense to peruse an investment strategy that invests in holding periods of more than one year anyway. Check out this article on why you will fail at trading. It shows how difficult trading in the short term really is.

If you think you might want to hire us to help prepare your taxes, please contact us here.  Our email is taxservicesoahu@gmail.com and our phone number is 808-744-5314. Aloha.

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